Does the mixture of debt and equity in a firm's financial structure matter Why - Essay Example

Primarily the equity shares are issued at ‘Par value’ but subsequent issues are made at premium. The company can finance its capital and revenue expenditure through the issuance of these shares or through its internally generated funds. The shareholder’s equity, as presented in the statement of financial position, comprises of retained earnings and issued and subscribed shares. Retained earnings are the accumulated profits from the period the company was incepted. These retained earnings or internally generated accumulated funds can also be utilized by the company in financing its assets.

Debts are classified into current and non-current. Current debts include items such as accounts payable, accruals etc which arise in the normal course of business and pertain to company’s day to day operations. In order to understand the impact of debt in the capital structure of a company, it is imperative that the company should clearly get acquainted with the concept of debt. There is no universal agreement between the financial analysts all across the corporate sector when it comes to identifying what constitute a debt.

It is considered a general notion that the long term debt as appearing in the balance sheet of the company constitutes the debt in the capital structure of the company. However, this definition of debt is way too broad and it includes the credits and short term overdraft of the company as well. The impact of debt on the capital structure can be analyzed from two different perspectives of financial accounting and financial management. Educated investors only invests in companies analyze several ratios such as current ratio, quick ratio and debt to equity ratio.

Current ratio is quite important from the investor’s perspective as it tells the state of liquidity of the company and would it be able to pay off its long term debts in the future. The most commonly used liquidity ratio, the current ratio, which is calculated by comparing the current assets and current liabilities. The strengthened the current ratio the more ability the company has to pay its debts and short term obligations over the next 12 months. The asset test, which is also regarded as the quick ratio, is calculated by subtracting the inventory balance from the total current assert balance.

Out of the current assets mentioned, inventories are regarded as the one which takes comparatively more time to be converted into cash or cash equivalent. The gearing ratios indicate the level of risk taken by a company as a result of its capital structure. These ratios are a great source of determining the level of financial risk to which the company is exposed and thus helps in reducing it to the optimum. The equity ratio indicates how much of the entity’s assets are financed through the finances generated through the revenue generated from the operations of the entity and raising financing through equity issue rather than acquiring debts or other financial institution.

In addition to the above, the cost of raising funds in the form of loan acquired from the bank or financial institutions is substantially less as compared to the cost of raising financing through shares or bonds. The cost of raising equity comprises of printing of shares, cost of listing the equity shares on the stock market